Establishing
a "Green Fields" operation has been unequivocally the preferred
(and sometimes only) choice for foreign companies entering China.
However, with
the relaxation of many industry-related regulations, increasing sales
of State Owned Enterprises (SOE) and restructuring of Foreign Invested
Enterprises (FIE) in China, the opportunities for Mergers and Acquisition
(M&A) activities are booming, and many foreign companies are exploiting
the newfound investment methods. At the same time, it is important
for foreign companies looking for M&A opportunities to understand
the China market, the M&A process and regulations in China and,
most importantly, what they are buying and for how much.
M&A in China
is not just about buying an onion from a Greengrocer, it requires
understanding where that onion was grown, where it has been and what
lies beneath its skin.
Get in Whilst the Market
is Getting Hot!
China has committed
to establishing itself as the manufacturing center of the world.
At the same time China's commitment to the WTO will result in an
explosion of service industry opportunities across finance, logistics,
professional services and other such services over the coming years.
With this rapid
opening up of the market, many companies realize that starting a
green fields operation may mean they miss the boat. In contrast,
taking over a well-established existing company cuts-out the build
up phase and cuts the time to market. By acquiring an existing entity
the risk of failure may be minimized and the acquiring company may
take advantage of existing operating facilities, distribution networks,
production knowledge, intellectual property and existing financial
and legal structures (e.g. tax losses carried forward, branch offices
etc.).
With this in
mind and in awareness that many domestic Chinese manufacturers are
already producing high quality goods at low cost, foreign companies
are beginning to capitalize on China's lucrative manufacturing base.
Likewise, as foreign companies restructure and look to spin-off
operations there are an increasing number of profitable and efficient
FIEs up for grabs.
The China Process
Ensuring
an M&A deal is completed effectively and efficiently requires
strict adherence to a process which in China, primarily including;
Objectives:
Foreign companies must understand what they are trying to achieve
through an M&A transaction, as this will greatly affect their
choice of target industry, market segmentation, geography, corporate
structure, operating objectives, taxation implications and business
scope.
Target Identification:
Having established clear objectives and industry focus, foreign companies
must then target specific types of companies (e.g. SOE vs FIE Vs Domestic)
which will satisfy these objectives. This decision will be based on
considerations of corporate transparency, regulatory restrictions
and required approvals, existing and ongoing liabilities, asset size,
reasons for wanting to be acquired/merged, management capabilities,
distribution abilities etc.
Due Diligence (DD) and SWOT analysis: The due diligence involved
in any M&A in China deal can be a tricky process, particularly
because many domestic Chinese companies may be uncooperative in disclosing
their records. Under such circumstances, most foreign investors will
require comprehensive representations and warranties, indemnities
for breach, and security for those indemnities. These arrangements
are often unfamiliar to many Chinese companies, and obtaining acceptable
terms and conditions that incorporate them is often a challenge.
In conducting
DD in China it is essential to understand Chinese accounting standards,
regulations, law and business practices. In China these areas overlap
to a very large degree (primarily due to the rules-based systems of
law and accounting). Regulations which are often misunderstood by
foreign companies and provide the most risk through an M&A deal
include:
1. Statutory
Benefits and Individual Income Tax;
2. Corporate taxes (including VAT, Business Tax and Income Tax);
3. Commitments and Contingencies;
4. Industry Regulatory Restrictions and Controls;
5. Related Party Transactions; and,
6. Off balance sheet items.
Planning: In China any profit or loss derived from the transfer
of real properties or intangible assets is subject to business tax
at the rate of five percent. The legislation that governs this tax
is therefore applicable in any M&A activities that involve the
transfer of assets such as real property and intangibles, such as
copyrights and trademarks. In an acquisition where the acquiring company
acquires all the shares, or equity interest in the target company,
the business tax consequences will depend upon the shareholding structure
of the target company. At the same time, the investing entity may
also be provided dual tax relief from any China taxes (such as withholding
tax or dividend tax) through tax treaties. This may impact decisions
on the best jurisdiction for the holding company to be located.
The basic accounting
rules concerning M&A stipulate that the new or surviving FIE will
be entitled to the remainder of applicable tax holidays (where certain
requirements are met) but to no new tax holidays, and that the assets
of the pre-merger FIE must be carried over on the books to the new
or surviving FIE at book value.
Companies wishing
to spin-off assets/companies must carefully consider the tax implications
of any proposed transaction such as whether it is better to sell the
assets or company as a whole, and whether/how much tax losses can
be carried, and over what period.
What is Best for your
Operations?
Form
of transaction:
China's evolving M&A regulations, combined with high tax rates
and non-transparent industry regulations often mean that the most
efficient method of acquiring or spinning-off assets may often be
to conduct the transaction 'offshore'. Key items for consideration
include:
1. Investment
vehicles:
Many FIEs in China
operate under a holding company, usually based in Hong Kong or other
tax efficient jurisdictions. If an investment in China is held in
such an arrangement a second offshore company can simply purchase
the shares of the first company under the laws of the applicable foreign
jurisdiction.
In keeping the
entire transaction outside of China, the Chinese government is not
permitted to regulate such actions and the foreign investor will not
need to seek their approval. Indeed, when establishing operations
in China, many FIEs structure their investment through intermediate
offshore holding companies, precisely to permit such flexibility for
any subsequent transfer of their interests.
2. Type of
Activity:
So long as the
M&A takes place within Chinese jurisdiction, according to a provisional
regulation released in April 2003 guiding foreign investor's M&A
activities in China, such activities are divided into two categories:
equity M&A and assets M&A.
1. Equity
M&A refers to a transaction where foreign investors purchase
by agreement the shares of a Chinese domestic company or subscribe
for an increased proportion of the shares in a domestic company.
2. Asset
M&A refers to an individual FIEs purchase and operation
of a company's assets, though sometimes this might also include
a situation whereby that FIE will establish a new FIE so as to operate
the newly acquired assets.
The adoption of
an asset deal or a share deal for an acquisition in China largely
depends on the individual commercial and tax objectives of different
foreign investors. These may include limiting existing liabilities
of a company, changing of business operations or structural considerations.
Generally speaking
there are a range of forms and M&A activities available to investors
and it is important to carefully consider each one depending on the
circumstances, tax considerations, ongoing strategy etc.
3. Exit strategy
As is the case
in setting-up any new business it is of utmost importance to consider
the exit strategy of the company should the entity wish to be closed
down or later sold.
For this reason,
using holding companies for M&A activities provides a practical
solution, although tax implications must be considered. For example
a foreign company that does not have an establishment or place of
business in China that sells an equity interest in an FIE will be
subject to the payment of a withholding tax of 20% on any gain realised
from the sale of the equity interest. This rule would therefore apply
to an offshore holding company that sells a joint venture stake in
China and has no other presence in China.
Where companies
wish to close down their operations in China, a liquidation is generally
required. Liquidation of an FIE must be approved by Ministry of Commerce
and certain procedures must be followed including establishing liquidation
committees, payment of creditors, clearing of liabilities and payment
of outstanding taxes.
Purchase Price:
Price negotiations in China often resemble haggling matches witnessed
in local markets. This problem is further exacerbated due to the limited
market information in China (e.g. price/earning ratios or appropriate
risk discount factors) and also the difficulties in predicting future
cash flows or revenue streams based on non-transparent accounting
records and a rapidly developing domestic consumer market.
In consequence,
and as a result of historical and cultural factors, it is often the
case that asset valuations are used rather than more common Discount
Cash Flow (DCF) models. This is particularly the case for manufacturing
operations where it is much easier to attach value to equipment and
land and then simply estimate a value for goodwill on top. This method,
however, is becoming more problematic as Intellectual Property and
branding (Intangible Assets) become more valuable in China and manufacturing
efficiencies are rapidly improving.
Where as there
is some flexibility in pricing limited liability of private companies
in China, SOEs are a separate matter. In acquiring or selling a SOE
a state-registered valuer must perform an independent valuation of
the SOEs assets. This process often proves to be a deal-breaker however
as the government is often bound by these often overvalued valuations
when it comes to negotiating price. On the other side, the foreign
company is faced with potentially paying a large premium over assets
which may be very run-down, with little movement for price "negotiation".
Regulatory procedures: Not only do the relevant laws and regulations
closely administrate M&A, but one or more Chinese governmental
authorities must also approve every type of merger or acquisition
in China, making the entire process rather daunting and time-consuming.
The specific procedures
for approval differ slightly depending upon the type of transaction,
but there are several common characteristics. Since nearly all M&A
deals in China involving foreign investors will result in the creation
of a new FIE or an alteration to an existing one, the approval of
the Ministry of Commerce is required. Whether an FIE should seek the
approval of state or the local office generally depends on the FIEs
total investment amount, which must be stipulated in the FIEs approval
documents.
Once the transaction
has been approved, the FIE must apply for a business license, which
would then include any changes to the previous license made necessary
by the merger or acquisition, particularly if a transaction resulted
in a FIE acquiring a line of business not already authorised by its
existing business license.
International Experience
and Local Knowledge
The
ability to buy, sell or merge companies in China represents a new
paradigm for foreign companies to enter the market. The professional
services firms and investment banks in many countries around the world
have the experience and resources to negotiate multi-billion dollar
deals across a number of continents. However, in China only local
knowledge, local experience and local appreciation of the business
environment will prevail.
Whilst the AOL
and Time Warner's of the world are only handled by the most exclusive
green-grocers, sometimes you need to go back to farm in China to see
where and how the onion bulb was first planted to understand what
you are buying.
Michael
Pennington LehmanBrown, Shanghai.
